Monetary policy and central bank interest rate policies
Monetary policy changes interest rates and the money supply to keep prices stable. In Sri Lanka it is run by the Central Bank of Sri Lanka.
Monetary policy in Sri Lanka
Monetary policy is the management of interest rates, money and credit by the central bank. Under the Central Bank of Sri Lanka Act No. 16 of 2023, the CBSL's main objective is domestic price stability, together with financial system stability. The CBSL follows a flexible inflation targeting framework: it sets its policy interest rate to keep inflation near a target over the medium term, while paying attention to growth and financial stability. Tight (contractionary) policy raises interest rates to cool demand and inflation; easy (expansionary) policy lowers them to support borrowing and growth.
Instruments of monetary policy
| Instrument | How it works | To tighten |
|---|---|---|
| Policy interest rate | The central bank's main signal rate (in Sri Lanka, the Overnight Policy Rate since November 2024); it steers overnight interbank rates and guides all other rates | Raise it |
| Open market operations | Buying or selling government securities to add or remove money in the banking system | Sell securities (absorb money) |
| Statutory reserve ratio | Share of deposits banks must keep with the central bank; it limits how much they can lend | Raise the ratio |
| Standing lending and deposit facilities | Overnight windows that set a ceiling and a floor for market interest rates | Raise both rates |
| Direct controls and moral suasion | Credit limits or guidance to banks on certain types of lending | Restrict lending to selected sectors |
| Foreign exchange operations | Buying or selling foreign currency, which changes rupee liquidity and the exchange rate | Sell foreign currency (absorbs rupees) |
How monetary policy works (transmission)
Other channels: asset prices and wealth, the exchange rate (higher rates attract capital and support the rupee), and expectations of future inflation.
Worked example: credit creation and the real interest rate
(a) Suppose banks must keep a reserve ratio of 10% (illustrative) and the central bank adds Rs. 1,000 million of new reserves. What is the maximum increase in deposits? (b) A bank lends at 12% a year while inflation is 5%. What is the approximate real interest rate?
- (a) Simple deposit multiplier = 1 ÷ reserve ratio = 1 ÷ 0.10 = 10.
- Maximum increase in deposits = 10 × Rs. 1,000 million = Rs. 10,000 million.
- A higher reserve ratio lowers the multiplier, so raising it is a tightening tool.
- (b) Real interest rate ≈ nominal rate − inflation = 12% − 5% = 7%.
(a) Up to Rs. 10,000 million of new deposits (multiplier 10). (b) Real interest rate ≈ 7%.
Tight and easy money
Central bank interest rate policies around the world
Interest rate decisions by major central banks, such as the US Federal Reserve, spread across the world. When they raise rates (as many did in 2022-23 to fight inflation), investors move money towards those countries, so developing-country currencies tend to weaken, their import costs rise, and their foreign borrowing becomes dearer. A small open economy such as Sri Lanka must consider these global moves when it sets its own policy rate, alongside domestic inflation and growth.
Limits of monetary policy
- Time lags: interest rate changes take many months to affect inflation fully.
- Weak transmission if banks are unwilling to lend or firms unwilling to borrow.
- Liquidity trap: when rates are already very low, cutting further has little effect.
- Supply shocks: higher interest rates cannot lower the world price of oil.
- Large government borrowing can push rates up and work against the central bank.
When the CBSL raises its policy rate, banks such as Commercial Bank and Sampath Bank raise loan rates, so leasing, housing and business loans become dearer and demand cools. When it cuts rates, firms find it cheaper to fund stock, machinery and expansion.
Short answer: “Name two instruments of monetary policy.” The policy interest rate and open market operations (also the statutory reserve ratio).
Structured question: “Explain how a rise in the central bank's policy rate reduces inflation.” Bank lending rates rise, borrowing and spending fall, aggregate demand shifts left, and price pressure eases; the currency may also strengthen, lowering import prices.
Essay: “Explain monetary policy, its instruments and how it works, with reference to the Central Bank of Sri Lanka.” Define monetary policy and the CBSL's objective, explain each instrument, show the transmission mechanism, compare tight and easy policy, and note global rate effects and limits.
Rate up → loans dearer → spending down → inflation down. CBSL tools: P-O-S (Policy rate, Open market operations, Statutory reserve ratio).